There are a few timeless laws you simply have to follow if you want to make money investing.

You can do everything else wrong but if you follow these laws you are virtually guaranteed to make money in the stock market over the long term.

I was going to do a lot of research to come up with my best ideas of the laws but then I read a March 2011 paper by a market strategist, and now also fund manager, I greatly respect and have followed for a long time.

He also works for an investment firm that does excellent work. The quarterly letter of the CEO which I recommended in the article The only quarterly market letter and worth reading is a must read.

The paper was called The Seven Immutable Laws of Investing and it was written by James Montier.

I have put together a page where you can read a lot of James’ previous writings. You can find it here: James Montier Resource Page

If you really want to improve your investment skills spend some time reading the research papers on this page.

Like me, James is a passionate value investor. It is thus not surprising that a lot of these laws come from what other great value investors such as Benjamin Graham, Warren Buffett, David Dreman and others have said.

Here are the laws:

 

1. Always insist on a margin of safety

2. This time is never different

3. Be patient and wait for the fat pitch

4. Be contrarian

5. Risk is the permanent loss of capital, never a number

6. Be leery of leverage

7. Never invest in something you don’t understand

 

Sounds simple enough doesn’t it?

But implementing them all will most likely take you a lifetime.

Now for a bit of information on each of the laws.

 

1. Always insist on a margin of safety

The concept of a margin of safety is probably one of the most important things Benjamin Graham taught us as value investors.

The valuation of the company you are buying is probably the most important factor that will determine your future returns.

You always want to make sure that you do not buy an investment at fair value but below fair value so that you have a margin of safety should something go wrong with the company.

And because valuation is an imprecise science a margin of safety gives you the added security in case you did something wrong in your calculations.

For me a margin of safety means researching only companies that are valued a lot cheaper than the market.

I will be the first to admit that these companies are not perfect, that’s the reason why they are cheap. But numerous research studies have shown that just randomly buying a portfolio of the most undervalued companies will ensure that you beat the market over long periods of time.

What I have done over the past 20 years is look at a lot of research studies and combined the factors that led to the companies outperforming the market. I’ve combined all these factors into a model that I used to select and evaluate the investments I make.

This has led to me substantially outperforming the market over long periods of time.

In the resource page I mentioned above (here’s that link again: James Montier Resource Page)

James mentions a lot of these factors that have led to market outperformance. Working through the research papers will give you the opportunity to put together your own list of factors to look for.

Also GMO, the company that James works for, each month publishes a seven year asset class forecasts that has proven to be surprisingly accurate.

You can use this as a guide to show you where undervalued securities can be found. Here is the web address: GMO website (free registration required)

 

2. This time is never different

James mentioned that Sir John Templeton defined “this time is different” as the four most dangerous words in investment.

Whenever you hear talk of a new era (remember “clicks not bricks”, in the Internet bubble) you should make sure that you start running in the other direction.

3. Be patient and wait for the fat pitch

Patience is a very important trait of a value investor. When investing patience is required not only while you are waiting for the companies you bought to be re-valued but also because you have to be patient and wait for an undervalued opportunity to appear before investing.

In times like the Internet bubble it may be very frustrating as you may be sitting on cash, searching for an undervalued investment, while the market and the returns of your friends are going through the roof.

Well you know how that turned out; investor did well for a year or two but thereafter lost everything when the bubble deflated.

 

4. Be contrarian

Value investors tend to naturally act contrary to the popular investment trends because trendy companies offer no margin of safety.

When others are selling you are normally buying and when others are buying and talking about stocks all the time you are most likely selling or have sold already.

This is not easy to do. Humans are by nature herd animals and are much more comfortable doing the same thing as everybody else than standing on the side line either watching or doing the exact opposite to what all your friends are doing.

 

5. Risk is the permanent loss of capital, never a number

With this law James refers to institutional investors who would like to define risk as a single number. Think of all the terms like beta, standard deviation and value at risk (VaR) you have heard before.

This is however not the case. Risk is a multifaceted idea that cannot be reduced to a single number.

James then names three risks that can permanently impair your capital:
1) Valuation risk – you pay too much for an asset;
2) Fundamental risk – there are underlying problems with the asset you have bought (for example a value trap); and
3) Financing risk – leverage.

6. Be leery of leverage

Debt is a dangerous animal. And adding debt to a bad investment can never make it better.

Also simply adding debt to a low return investment doesn’t transform it into a good return generator.

As you know value investing requires patience and if you have invested with debt the repayment of the debt may come at exactly the time when it will be most critical for you to hold onto your investments.

Being forced to sell may turn an undervalued investment (that is now even more undervalued because of a market decline) into a permanent loss of capital because you are forced to sell.

This may look like a law that is far too simple to be included in the timeless laws of investing but I can assure you it isn’t.

I cannot remember the number of times I have advised friends to simply say no when their bank offers them some structured product that would

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